Germany is the defacto leader of the EU and European Central Bank (ECB) and has benefitted from the union. Passive bond investors in managed funds and ETFs need to be aware of rising sovereign risk
Germany is the defacto leader of the EU and European Central Bank (ECB) and has benefitted from the union. They are the largest economy, in the best economic position and the largest lender to EU members. And while there is little evidence suggesting the EU was designed to create economic advantage for Germany, in hindsight the advantages it has gained relative to rest of the EU are significant. This is likely to be used by anti-EU political parties in 2017, much as Boris Johnson (Brexit campaign leader) and Trump did in 2016. As political risk increases, so too will nervousness and therefore volatility in financial markets. Passive bond investors in managed funds and ETFs need to be aware of rising sovereign risk.
The EU will break up and it will be Germany’s fault. Of course the future is never that certain, but the chances of an EU breakup have been constantly rising since the GFC. We flagged this in our economic outlooks from the middle of 2014, highlighting the various economic, demographic and political headwinds since.
The 2016 UK vote to leave awoke world financial markets to a new global risk: populism; and increased the odds of an EU breakup. The so-called PIIGS, Portugal, Ireland, Italy, Greece and Spain, are treading water at best and heading for default at worst. France is in relatively strong economic health, but has unemployment higher now than when the EU was formed, its fiscal deficit is high and rising. Populism is strong and on the rise and with it, populist policies calling for the end of austerity measures, freedom of migration and more often than not, departure from the EU. Bookies, while hopeless predictors of Brexit and Trump, have 2/1 (33%) odds on Italy leaving next and 7/2 (22%) on France being next.
Populism has risen as a result of nearly a decade of record high youth and long term unemployment. Unemployment has societal impacts, with 50% of unemployed Europeans now looking for work for more than 12 months (compared to 18% in the US and 24% in Australia). Youth unemployment is 20% across the whole of the EU, and as much as 50% in Spain, Italy and Greece.
But Europe’s woes have been well covered already. What hasn’t been well explored by investment researchers or the media, is the complicit role that Germany is playing in the issues the rest of the EU now face. As this year’s elections in France, Netherlands, Germany and possibly Italy approach, it is fair to assume the anti-EU parties like Marine Le Pen’s National Front will be pulling out this sort of evidence and making the public aware. Then, like in Britain and the US in 2016, the people will have a chance to make up their own minds.
The evidence against Germany is strong. As shown below, the EU would appear to have benefitted Germany but has been poor for most of the rest of Europe. If you look at every other nation, there are some exceptions like The Netherlands, but the major beneficiary has been Germany:
Who has benefitted from the EU?
Economic scorecard, data is 2016 unless otherwise stated
| | Germany | France | Italy | Spain | Rest of Europe |
| Unemployment | 4.4% | 10.0% | 11.5% | 19.7% | 11.4% |
Change in unemployment since
pre-EU (1988-1992 average) | -1.7% | +2.2% | +2.8% | +3.5% | +1.7% |
| Youth unemployment (2015/16) | 7.0% | 26% | 36% | 44% | 20% |
| Trade surplus (% of GDP) | 9.0% | -2.0% | +2.8% | +1.7% | +3.6% |
| Fiscal surplus (% of GDP) | 0.7% | -3.6% | -2.4% | -4.6% | -1.9% |
| Debt to GDP ratio | 68% | 96% | 133% | 100% | 91% |
Source: FIIG Securities Germany has improved relative to the other major EU economies of France, Italy and Spain on all metrics. Unemployment and trade stand out though, and are the drivers of the social unrest and move to populism and anti-EU sentiment.
“In fact, the trade imbalance is so extreme , that Germany is now in violation of the Maastricht Treaty requiring no EU member state to have a surplus of more than 6%”.
The motive for Germany wanting to create an EU with strict constraints and trade barriers is not hard to understand. Germany went into the EU with the strongest manufacturing base in Europe, and as the strongest exporter. Its biggest challenge before the EU was the appreciation of the Deutschemark, weakening export competitiveness. Now Germany participates in a weaker currency, weakened by the issues facing many of the other EU members, allowing it to strengthen its manufacturing economy and exports. Each year, the rest of Europe remains relatively weak, while Germany gets stronger.
So goes the case of the populist movement in places like France, Italy, and Spain. Prior to the EU, the Italian Lira, the Spanish Peso and even the French Franc would have suffered significant depreciation given declining economic data, rising debt, crippling unemployment rates and for Italy, a banking crisis that looks beyond saving. Once upon a time, a weaker currency would have strengthened competitiveness in trade markets. But those countries can no longer extract any benefit from a weaker currency and worse still, are hamstrung when it comes to controlling socially sensitive issues such as migration, employment laws or bailing out their banks, thanks largely to the pressure applied by the Germans.
Under the EU structure, the Germans benefit from free trade and at the same time apply high tariffs on importing goods from outside the EU. Thus Germany continues to strengthen economically while its largest co-members suffer.
The unfortunate by-product is the strengthening anti-EU populism movement. The longer that Germany continues to push austerity on other nations, demands strict EU policies that restrict other countries’ perceived ability to mend their economies (such as the rules preventing Italy from bailing out its banks), and at the same time run their own budgets with a surplus rather than spending on infrastructure or on supporting the rest of the EU, the more likely the breakup of the EU becomes.
Implications
While few Australians have a meaningful allocation to European assets, large proportions of some fixed interest managed funds are held in European government debt. Most fixed interest managed funds closely track an index; the most popular of which is the Bloomberg Barclays Global Aggregate Index. A total of 31% of this index is made up of European sovereign bonds. Ordinarily, holding bonds in a crisis is a good thing, but when European bonds are artificially, thanks to quantitative easing (QE), sitting around 0%pa yield, there is too much risk of deteriorating credit quality coinciding with the ramping down of the ECB’s QE program. If this happens, yields on many of the major EU sovereign bonds, particularly countries like Spain, Italy and Greece, could rise very quickly causing losses for unaware Australian investors.
Now is not the time to be investing in index following or passive managed funds. You aren’t getting paid for the sorts of sovereign risks that exist in this counter intuitive global economic environment.